Monday, 13 July 2015

When
it comes to boosting exports, inflation matters at least as much as the
exchange rate.

The decision by the
Central Bank of Egypt (CBE) to let
the Egyptian pound depreciate was applauded by some
commentators. They argued that a weaker pound can boost exports by making
them cheaper relative to their competitors. However, even in theory, this
argument is incomplete and misses important ingredients. Careful analysis shows
that when it comes to boosting exports, inflation matters at least as much as
the exchange rate.

Let’s take an example.
Consider a situation in which Egypt and the US produce an identical good, which
they export to the rest of the world. Suppose that the price of the Egyptian
good is 100 pounds, and the price of the US-produced good is $100. Now, assume
that the exchange rate is such that 1 pound = $1. This means the price of the
Egyptian good in dollars is $100, exactly the same as the price of its American
counterpart. Consumers will therefore be indifferent between buying either.

Suppose that the
CBE then decides to let the pound depreciate by 10%, so that $1 = 1.1 pound. The
price of the Egyptian good is still 100 pounds, but its price in dollars is now
$91 (=100/1.1). Because the Egyptian good costs less than the American one
(which is sold at $100), consumers will choose to buy more of the Egyptian good
at the expense of the American one. This is exactly the argument that proponents
of the recent depreciation of the pound make.

Assume then that inflation
in Egypt is 20% but it is zero in the US. This level of inflation implies that
the Egyptian good now costs 120 pounds. This
is equivalent to $109 (=120/1.1). The Egyptian good is now more expensive than
the American one, which still costs $100. Inflation has basically wiped out all
the competitiveness gains from the currency depreciation.

What are the
lessons of this simple example?

1. Inflation is at
least as important as the exchange rate when it comes to making exports more
competitive in international markets. In other words, it is real exchange rate
(which also takes inflation into account) not nominal exchange rate that
matters for exports.

2. With Egypt
running double-digit inflation and most of the rest of the world operating at
below 2% inflation rates, the CBE has room to improve the appeal of Egyptian
exports by reducing inflation, not just the value of the currency.

Of course, these
conclusions are under the assumption that Egyptian exports respond to
improvements in price competitiveness (equivalently, a fall in the real
exchange rate)—an assumption that is not uncontroversial. But this is another story.

Monday, 6 July 2015

Paradoxically,
by aiming for a lower budget deficit, Egypt may hurt its growth prospects and
end up with a higher deficit than it is hoping for.

There was some last-minute
drama in the release of Egypt’s budget for the current fiscal year which began
on July 1. The president, Abdel Fattah al-Sisi, rejected the initial
budget that was presented to him. He asked the Ministry of Finance to reduce
the deficit, which was expected to reach 281bn Egyptian pound (9.9% of GDP). In
the space of a few days, the ministry re-evaluated its figures and came up with
a revised budget and a new deficit of 251bn pound (8.9% of GDP). These events
raise two questions: How did the ministry manage to reduce the deficit by 30bn
pound? And can the new deficit be realistically achieved?

The answer to the
first question is that revenues were revised up by 10bn pound while
expenditures were revised down by 20bn pound. As the table below shows, the
higher revenues are a result of higher non-tax revenues, which include profits
from publicly-owned companies, the central bank and the Suez Canal. Why are these
expected to increase by 10bn pound now compared to a few days ago? It is not
clear.

Meanwhile, half of
the expected cut in expenditure (10bn pound) is due to lower spending on salaries
and wages. The other half comes from either decreased purchases of goods and
services or lower spending on other items (which include defence, national
security and judiciary, among other things). The published figures do not allow
for a full distinction.

Now, can the new
deficit be realistically achieved? Probably not, and for three reasons.

Second, commodity
prices—whose decline in 2014/15 helped control spending and reduce the deficit—are
projected to rebound. The budget expects oil price to average $70 per barrel in
2015/16, up from the current price range of $55-$65. This is likely to increase
the burden on spending, making it harder to achieve the 8.9% of GDP fiscal
deficit.

Third, and most
importantly, the revised budget assumes that the lower deficit has no impact on
growth. The initial budget assumed a growth rate of about 5% in 2015/16—the same
growth rate assumed under the revised budget, even after slashing the deficit
by 1% of GDP. The assumption that the reduced budget deficit will have no
growth impact contradicts the recent experiences of the US, UK and the Euro
Area. In each of these regions, tighter fiscal deficits had a significantly negative
impact on growth, and these economies only picked up when the drag from fiscal
policy dissipated. One would not expect the experience of Egypt to be any different.

And there is a
feedback loop from lower growth to the budget: Slower growth could result in lower
tax revenues and a higher fiscal deficit, the very thing the Sisi’s revision to
budget sought to reduce. Paradoxically, by aiming for a lower budget deficit,
Egypt may hurt its growth prospects and end up with a higher deficit than it is
hoping for.

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About Me (Ziad Daoud)

I am an economist currently based in the Middle East. I have previously worked for an asset management firm and, before that, I did a PhD at the London School of Economics. The views in this blog are solely my own.